Pecking Order Theory Analysis

Pecking order basically states that companies prefer internal financing opposed to external financing as well as debt oppose to equity if external financing is to be used. The last resort for companies is to raise equity. Steward. C. Myers was the first to popularise the pecking order theory when he argued that equity is less preferred when raising capital. The theory states that firms will choose internal financing when they can and choose debt over equity when internal financing is not an option and external financing must is used. Mangers overvalue firms to take advantage and as a result investors only place a lower value to their equity.

The first assumption of capital structure started with Modigliani and Miller’s (1958) proposition of the irrelevance of capital structure. Research however showed that the Modigliani and Miller theory proves to be incorrect under a wide variation of circumstances. Modigliani and Miller’s proposition included unrealistic means of how firms finance their operations it does however specify reasons why financing may matter. One of Modigliani and Miller’s unrealistic proposition that will help with this review were ‘that firms and individuals have the same information. Myers and Majluf improved this theorem of Modigliani and Miller as they suggested that firms and investors are unequal and that firms possess more information oppose to investors regarding the true value of the firm and the firm’s growth.

Myers and Majluf (1984) developed a model where capital structure choices are made to limit inefficiencies caused by asymmetric information. Asymmetric information is when the mangers of a firm know more about the value of the firm and its growth opportunities oppose to outsiders. Myers and Maj...

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...nd to issue equity, which disproves the pecking order theory.

There have been some disputes as to why small and high growing firms fail to follow the pecking order theory. One reason could be because they have less internal funds, as they are more likely to be financially constrained.

Studies suggest that the pecking order will provide a better description with regards to the financial behaviour when it comes to unconstrained firms. These firms will choose to issue debt unless the equity market is more favourable and the cost of issuing equity is less than issuing debt. On the other side constrained firms will choose equity oppose to debt, unless they can have access to the debt market. Lemmon and Zender found in their studies that financially unconstrained firms are more likely to follow the pecking order while constrained firms are not so likely to follow it.